An Actuarial Perspective Stefan Engeländer Lisboa, July, 7 th 2004

1. III International Conference Insurance and Pension Funds Practical Implications of IFRS 4 An Actuarial Perspective Stefan Engeländer Lisboa, July, 7th 2004

2. Agenda • International Actuarial Standards of Practice • Contract Classification • Unbundling • Embedded Derivatives • Discretionary Participation Feature

3. Agenda • International Actuarial Standards of Practice • Contract Classification • Unbundling • Embedded Derivatives • Discretionary Participation Feature

4. IAA and IASB • Close cooperation of IASB and International Actuarial Association (IAA) in developing IFRS for insurance contracts • No intend of IASB to provide technical details in IFRSs • Interpretation required since IFRS 4 often based on simplified examples applicable only in very narrow circumstances • Hence, IASB staff clarified in IASB Observer Notes January 2004:92. (d) Some argued that the Board (or IFRIC) should set up an interpretation panel to address questions that will arise in phase I. The staff notes that a sub-committee of the International Actuarial Association (IAA) has begun developing guidance for actuaries.

5. IAA and IASB • No official role of IAA in interpreting IFRSs • No official role of actuaries in establishing accounting policies or financial statements But: • IAA ensures a professional interpretation and comparable application of IFRS 4 world-wide • Actuaries to be involved in establishing accounting policies and financial statements • Consequence of responsibility of preparers rather than explicit rule

6. IAA Subcommittee IAA established International Actuarial Standards Subcommittee to • propose International Actuarial Standard of Practice (IASP) regarding actuarial work under IFRSs • develop educational material accompanying such IASP • support IAA member associations in implementing and applying those IASP Subcommittee established Drafting Team, preparing draft papers

7. IASP The IASP is to be adopted by all member organizations either • by making it binding for members directly or • by introducing an own standard, at least equivalent in binding force and content Classification of IASP in preparation: Class 4 Practice Guideline Examples of adequate behavior, merely educational, any alternative, assumed to be suitable by the actuary, is allowed

8. Due Process • Drafting Team prepares currently exposure drafts to be exposed by the president of the IAA in due course • Comment period to Washington meeting in autumn • After approval by Council, ballot vote of member organizations

9. Planned IASP • Actuarial Practiceregulation of actuarial behavior in agreeing, proceeding and reporting work • Contract Classificationinterpretation of definition of insurance contracts, investment and service contracts • Liability Adequacy Testminimal requirement, interpretation of IAS 37 • Discretionary Participation Feature • Embedded Derivatives • Reinsurance • Disclosure • Measurement issues for investment contracts • Changes in Accounting Policyinterpretation of guidance provided in IFRS 4

10. Agenda • International Actuarial Standards of Practice • Contract Classification • Unbundling • Embedded Derivatives • Discretionary Participation Feature

11. Insurance Characteristics Classification of most contracts in mass business trivial Main features causing trouble • What is significant insurance risk? • Life insurance with large investment component and negligible insurance coverage • What are the borders of one contract? • Group contract or group of contracts? • Sequence of contracts or one contract? • How to ensure that all contract features are adequately considered? • Complex reinsurance constructions

12. Significant Insurance Risk Events of commercial substance: Normally clear, anything • where market participants are willing to pay for • Premiums charged explicitly for that risk • where market participants take effort to avoid/reduce risk • Effective risk examination at outset • Taking (re-)insurance for protection

13. Significant Insurance Risk Significant additional benefits: More difficult • Significant • Rebuttable presumption: above 10 % significant • Judgment required, but significance doubtful: 5 %- 10 % • Up to prove of contrary unacceptable: below 5 % • Comparison value: • Normally surrender value plus surrender charge at death date • Surrender value or surrender charge might be artificial and economically meaningless • Theoretically: Comparison of value of contract from policyholders view point in case of occurrence of insured event with the value in case of any other event of commercial substance. • If maximal difference is significant, there is a significant additional benefit

14. Borders of the contract Major question in case of group policies: • Is the group one contract? • Is each risk covered in the group one contract, just grouped for administrative purposes? Important, if • risk equalization effect in the group is so significant • premium adjustment clauses apply that insurance risk on group level is not significant Terms of group agreement need to be investigated, whether • each individual risk ort • the entire group comply with the definition of a contract in IAS 32.13

15. Borders of the contract Life of the (insurance) contract 1 Significant insurance risk 2 Significant insurance risk 3 Significant insurance risk Term life insurance: Risk remains significant throughout the contract Endowment policy – amount at risk in case of death reduces as value of investment component increases Deferred annuity – no insurance risk during savings phase, insurance risk in annuity phase; overall insurance since opting for annuity is an event of commercial substance, except if annuity factor is bilaterally negotiated, enabling to determine prohibitive factors.

16. Consideration of all Features Traditional problem in reinsurance: How to ensure that all contractual features are adequately considered and properly reflected? • Fantasy of reinsurance actuaries to style reinsurance treaties unlimited, hiding financing features – reinsurance no mass business • If a financing feature is fully hidden, unbundling is no threaten and it is not possible to measure the significance of the existing insurance risk properly • But: Reinsures should be able to link each financing agreement with at least significant insurance coverage • IFRS 4 less strict than US-GAAP

17. Agenda • International Actuarial Standards of Practice • Contract Classification • Unbundling • Embedded Derivatives • Discretionary Participation Feature

18. Unbundling IFRS 4.10 prohibits unbundling of a deposit component if • not measurable separable, ie without consideration of the insurance component and allows it in all other cases. IFRS 4.10 requires unbundling of a deposit component if • it is allowed • recognition of all rights and obligation under the deposit component is not required by existing accounting policy

19. Unbundling EU Directive 2002/83/EC (Life Insurance Directive) Article 20 1. A. (i): As provisões técnicas de seguro de vida devem ser calculadas segundo um método actuarial prospectivo suficientemente prudente que tome em conta todas as obrigações futuras de acordo com as condições fixadas para cada contrato em curso, ... • In Europe, in applying the directive, all obligations considered • Normally existing accounting policies require recognition of all rights • Relevant is recognition (ie consideration in actuarial formula), disregarded of measurement • Complex contract constructions might cause that rights or obligations are not noticed, causing non-recognition but no unbundling

20. Agenda • International Actuarial Standards of Practice • Contract Classification • Unbundling • Embedded Derivatives • Discretionary Participation Feature

21. Derivatives and Embedded Derivatives Embedded derivatives are not derivatives embedded in other contracts Derivative: • Stand-alone contract • subject to IAS 39 (ie not subject to IFRS 4) • with specific features as defined in IAS 39.9 • especially reflecting concentrated market risk Embedded derivatives (IAS 39.10): • Component of another contract (need not to be stand-alone a derivative, ie it can include insurance risk) • Explicit clause modifying cash flows of contract payable otherwise • Varying in response to market factors

22. Derivatives Embedded in Insurance Contracts Derivative embedded in an insurance contract: • component of the contract (ie forming separated an economically reasonable contract which includes earnings and expenses) • stand-alone in compliance with the definition of a derivative (especially not containing significant insurance risk) • Needs to comply with all requirements in IAS 39.9 • Value provable responses to changes of specified market factor • Initial net investment lower than for alternative investment

23. Derivatives Embedded in Insurance Contracts • A derivative embedded in an insurance contract is subject to IAS 39 and to be separated if and only if IAS 39.11 determines that, except if exempted by IFRS 4.8 • An embedded derivative, not qualified as a derivative embedded in the contract, is not subject to IAS 39, except if separated in cases allowed by IFRS 4 and the separated component is not in the scope of IFRS 4 • Any embedded derivative subject to disclosure requirements of IFRS 4.39 (e) if not reported at fair value

24. Separation of Derivatives Embedded derivative is no derivative and therefore never separated if • Containing significant insurance risk (in relation to the component) • guaranteed insurability • double trigger • No alternative investment with lower initial investment available • Annuity option • Other non-traded factors (eg claim indices) Derivative embedded in an insurance contract is not separated if • closely related • not measured already at fair value • not a traditional surrender option or something equivalent

25. Agenda • International Actuarial Standards of Practice • Contract Classification • Unbundling • Embedded Derivatives • Discretionary Participation Feature

26. Discretionary Participation Feature Definition of DPF focused on UK situation: • Contract grants insurer discretion to decide for the entire surplus Continental European situation is deviating: • Contract grants insurer discretion regarding timing of recognition of surplus and allocation to individual policyholders • Amount is a contractually fixed share of surplus • Insurers have the ability to over-perform voluntarily obligations and pay for competitive reasons amounts in addition to obligatory amount, but not granted by contract

27. Discretionary Participation Feature Most relevant features of definition of DPF • Additional benefit is contractual right (no constructive obligation) • Discretion is granted explicitly by contract • Additional benefits based contractually on surplus Consequences: • Universal-life interest no DPF, since additional benefit not based contractually on surplus • Voluntary payments no DPF, since discretion not granted explicitly by contract

28. Discretionary Participation Feature Typical Continental European example • Basis of participation statutory surplus • Timing of realization or distibutability of investment gains at the discretion of the insurer • Policyholders’ share in surplus is a contractually fixed percentage • Insurer may pay voluntarily additional amounts based on competitive pressure Application of DPF-Definition: • Timing of realization or distributability qualifies as discretion • Percentage share of policyholders in surplus qualifies as connection to surplus  Contract contains DPF

29. Discretionary Participation Feature DPF comprises • those additional benefits paid under the contractual right • not the entire additional benefit, if reflecting competitive pressure rather than share in surplus Voluntary payment in addition to legal share is not part of DPF, since • is not paid based on a contractual right of policyholders • the discretion to pay that amount is not granted by the contract and not contractually based on surplus • the amount is not determined based on surplus but on competitive needs irrespective surplus (no incremental relation to surplus)  No need to report any amount paid voluntarily in future as liability before a legal or constructive obligation is established

30. Discretionary Participation Feature Consequence: Entire DPF is classified as liability, if the insurer classifies as liability • any amount already legally allocated to policyholders • the contractual percentage of any surplus • reported under statutory accounting but not ultimately allocated to policyholders since subject to future performance (policyholders have no right to get more, but might get less) • reported under IFRSs but not yet reported under statutory accounting  Future voluntary payments are not anticipated but expensed and to be reasoned to the owners when the legal binding decision is made, there is – in difference to the situation in UK – no contractual constraint earlier